‘Tis an Illiquidity that Blows No Good

Financial and economic news increasingly report on the term “liquidity” and its antonyms “low liquidity” and “illiquidity”.

For example, Business Insider (“This week’s gold crash reminds us of a much scarier risk in the markets”) warned that on Monday, July 20th,

“. . . gold crashed by more than 3% in just a matter of seconds. . . . [E]xperts are still trying to come to a consensus over the cause of the stunning move. . . . But all of these theories are more or less tied to one theme . . .: low liquidity. . . .

“Current concerns in the financial markets center around the absence of liquidity and the effect it might have on future market prices,” Janus’ Bill Gross said in June. “In 2008/2009, markets experienced not only a Minsky moment but a liquidity implosion . . . .

“Liquidity is a concept that is universal in the markets. And sometimes it will just vanish without warning. . . .”

“Low liquidity is bad almost any way you look at it.”

OK, OK, OK—the concept of “liquidity” is “universal” and, like a magician’s assistant, it can mysteriously vanish or appear at any moment. “Low liquidity” is universally bad and therefore an “ill” liquidity—or, for short, “illiquidity”.

We get that.

And we sure don’t want another “liquidity implosion”—do we?

No.

In fact, we’re all united in our adamant opposition to “low liquidity”—but what th’ heck is it that we’re all opposed to?

What, exactly, do the terms “liquidity” and “illiquidity” mean?

Definitions

• The Telegraph quoted the IMF as defining liquidity as,

“The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.”

Say whut?

I didn’t quite get that. The definition was a tad too “professional” for me.

• Business Insider defined “liquidity” as follows:

“Broadly speaking, liquidity measures how easily traders and investors can buy and sell an asset in the market without seeing big price dislocations. When liquidity is low, selling can cause prices to plummet.”

“Oaktree Capital’s Howard Marks offered a . . . philosophical definition: “The key criterion isn’t ‘can you sell it?’ It’s ‘can you sell it at a price equal or close to the last price?‘ For them [investments] to be truly liquid in this latter sense, one has to be able to move them promptly and without the imposition of a material discount.”

“Deutsche Bank’s Peter Hooper said, ‘. . . there is no single best metric for the level of liquidity in a market.”

Maybe, “liquidity” is like obscenity: economists can’t exactly define it, but they know it when they see it.

“Not only is liquidity underappreciated, but it’s also much more complex and nuanced than in the above definition.”

Description

Everyone seems to agree that low liquidity or “illiquidity” is a problem (even a threat), but there doesn’t seem to be much agreement on what “liquidity” and its antithesis “illiquidity” really mean.

2) Not cause their investment’s price to fall as a consequence of the sale.

As an hypothetical example, suppose I owned $1 million in GM stock and I wanted to sell it. In a highly liquid market, I could “easily sell” my stock for the full price (more or less the $1 million I’d invested in GM)—and, the stock’s market price would stay at $1 million.

But if the market was illiquid, I’d have a hard time finding a buyer at any price, and when I found one, he’d want a significant discount. I.e., he might offer me only $800,000 for my $1 million in stock. Illiquidity would cause me to suffer a big loss.

More, illiquidity is contagious. If I accepted that $800,000 offer in a low liquidity market, the stock’s former price of $1 million could “officially” fall to $800,000 for all subsequent sales of that stock. Thus, in an illiquid market, if I accepted $800,000 for my $1 million investment, and if you’d also invested $1 million in GM and wanted to sell, you would also have to accept the $800,000 price (and $200,000 loss) that I’d previously accepted. By accepting $800,000 I could have caused the market price to fall by 20%.

Worse, if low liquidity persisted, the next guy who tried to sell what had formerly been $1 million worth of stock, might only hope to sell at $800,000. When he tried to sell, the few buyers who’d consider his offer might refuse to pay more than $600,000. (That’s a 40% loss.)

Being contagious, illiquidity can not only cause dramatic price declines, it can thereby precipitate panic among those still holding the GM stock. When the price is falling dramatically, everyone will want to sell. Almost no one will buy. The last guy to sell his $1 million in GM stock might be lucky to get $100,000.

It’s not so hard to provide a description of how illiquidity operates, but we still don’t have a workable definition.

Meet the PPT

The “Plunge Protection Team” (PPT; Working Group on Financial Markets) was created during the Reagan administration to protect the markets against the dangers of illiquidity.

During a period of illiquidity, if market prices started to fall, no one would be willing to buy at or near current prices and market prices would tend to “plunge” further towards annihilation. To stop such sudden and catastrophic episodes of illiquidity, the Plunge Protection Team (PPT) would enter the market and start purchasing the falling stocks with government funds. By purchasing the falling stocks, they’d provide liquidity (it would be easy to sell stocks without causing further prices declines) and stop the panic.

During the A.D. 2007-2009 Great Recession, the Federal Reserve stepped into falling markets to purchase “toxic assets” at full face value and thereby prevent the prices of those stocks or bonds from crashing. By making it “easy” for investors to sell (dump) their “toxic assets,” the Fed provided market liquidity that prevented the markets from remaining illiquid and crashing.

The concept of government providing “liquidity” is a great idea. Investors are thereby protected from catastrophic crashes that almost totally destroy investments’ value. The PPT acts as the markets’ insurance agent. They virtually “guarantee” that investors can’t lose everything during a market decline.

• However, there’s a problem. By establishing the PPT in A.D. 1988 (when the DJIA was about 2,100 points), the government created an artificial support for the markets. That support removed much of the risk in investing by implicitly guaranteeing that the markets could not fall significantly.

As seen in the market crash of A.D.2007-2008, that “guarantee” hasn’t been foolproof.

Still, given the PPT’s and the government’s determination to provide market liquidity, we’re left to wonder how much of today’s 17,000 points in the DJIA is real (due to free market fundamentals) and how much is illusory and due to market manipulation (artificial support) by the government, Fed and/or PPT.

The DJIA is up about 15,000 points since the creation of the PPT. How much of that 15,000-point gain would’ve taken place without the PPT? Without the PPT’s 27 years of protection against market illiquidity and market price crashes, would a truly “free” (unmanipulated) DJIA still be 17,000? Or would it be 8,000? Or, maybe, 5,000?

So long as the PPT is on guard, stocks can’t (usually) fall. The inability to fall can be expected to have caused stocks to riseirrationally. From that perspective, government’s guaranteed liquidity programs provide artificially, irrationally high market prices.

Over-priced stocks are a hallmark of investment “bubbles”.

Government’s and the PPT’s effort to inject artificial liquidity into the markets result in large, perhaps massive, “bubbles”.

Illiquidity, on the other hand, pops bubbles and pushes market prices down from artificial highs to levels that may be at or even below, rational free-market prices.

From this perspective, maybe it’s not true that ““Low liquidity is bad almost any way you look at it.”

Maybe illiquidity sometimes pushes us back towards reality and truth.

• In October, A.D. 2007, the DJIA peaked at 14,198. By March, A.D. 2009, the DJIA had lost 54% of its value and hit a market low of 6,443. That’s evidence of illiquidity. But, was that fall completely irrational? Or did it reflect the fact that the markets had been irrationally supported by the PPT for the previous 20 years and, as a result, the 14,000 Dow was 54% higher than fundamentals and the free market could justify?

Did 20 years of “Plunge Protection” protect us from a score of free-market mini-crashes that might’ve held Dow down around 7,000? Did the Dow therefore rise artificially to 14,000? Did the weight of all the mini-plunges that had been prevented by the PPT “accumulate” until they broke loose in a major crash in 2007-2009?

Since A.D. 2008, the Federal Reserve has injected over $3 trillion into US banks. It’s called Quantitative Easing (QE). It’s fairly common knowledge that most of that $3 trillion has gone into the stock markets. That $3 trillion has guaranteed market liquidity and pushed the Dow up from 6,443 to over 18,000.

How much of that 11,000 point rise was real and due to an economic “recovery”?

How much was illusory and based only on the PPT’s and Fed’s proviso of artificial liquidity where it might not otherwise exist?

• Can our central planners “fool Mother Nature” indefinitely by injecting unlimited, artificial liquidity into the markets? The central planners act as if the answer is Yes.

But, isn’t it obvious that there must be an objective limit to how large our liquidity “bubbles” can grow before they pop?

When the liquidity “bubble” inevitably pops, will that be a bad thing? Lots of investors will scream as they watch their “fortunes” disappear. But, did they really have a “fortune”? Or did they only have a paper illusion that was provided courtesy of the PPT’s and government’s promise that there’d always be market liquidity and so the market prices would always rise?

Illusions are lies. Destroying illusions may be painful, but is it wrong?

Aren’t we all better off if we return to some semblance of truth?

Ask a silly question

We’ve seen some examples, descriptions and consequence of “liquidity” and “illiquidity”. We’ve even seen some definitions that may be technically correct, but still seem hard to understand.

So, let’s see if I can provide working definitions of “liquidity” and “illiquidity” that might not be precisely accurate, but might still be useful.

The best way to find out what something mysterious is or means is to ask questions. If you can frame and then answer the right questions, they’ll tend to lead you, step-by-step, to a workable explanation or definition.

For example, as Business Insider opined, the most accurate definition of “illiquidity” may be too highly “complex and nuanced” to ever be truly understood by the great unwashed. But, for a simple country boy like me, a few questions can push us towards a fairly understandable and workable definition.

Let’s start with Business Insiders’ “broad” definition of “liquidity” as a premise and see if we can pick it apart with some questions:

“Broadly speaking, liquidity measures how easily traders and investors can buy and sell an asset in the market without seeing big price dislocations. When liquidity is low, selling can cause prices to plummet.”

Q: Why can’t people easily sell their investments during a time of “low liquidity”?

A: Because the potential buyers prefer to hold their cash rather than buy that particular investment.

Q: Why do potential buyers prefer to hold their cash?

A: Because the value and purchasing power of their cash is rising.

Q: Is there a commonly-understood, economic term that signifies circumstances when the purchasing power of cash is rising?

A: Yes—“deflation”.

Implication: “Low liquidity” and “illiquidity” are simply esoteric terms used to describe periods of deflation.

“Deflation” is usually a characteristic of an economic downturn, recession or, especially, a depression.

It follows that periods of “illiquidity” are consistent with deflation and economic depression.

Q: Are brokers and economists going out of their way to provide multiple and esoteric definitions of “illiquidity” because the concept is so complex, subtle and confusing?

A: I doubt it. I suspect that the absence of a single, clear definition of those terms is evidence taht brokers and economists provide confusing and imprecise definitions of “illiquidity” to avoid saying the “D-words”: “deflation” and, by implication, “depression”.

So long as the definitions of “low liquidity” and “illiquidity” are “complex and nuanced,” they’re unlikely to be understood by 99% of the American people. So long as the majority don’t understand those words’ meanings, use of those words is unlikely to cause much panic.

If the public understood that “illiquidity” simply meant or implied “deflation” (and “deflation” was a hallmark of economic depression), every time the central planners said “Illiquidity,” the public would be more likely to panic, sell their stocks, and collapse the markets.

• Economist’s use of words like “illiquidity” reminds me of parents in the 1950s who spoke in “pig Latin” to prevent their kids from knowing what Mom and Dad were up to. “Pig Latin” was achieved by moving the first letter of a word to the end of the word and attaching the “ay” sound. For example, the word “dad” became “ad-day”; the world “mom” became “om-may”. Parents might ask each other, “Ow-hay . . . oon-say . . . an-cay . . . e-way . . . ut-pay . . . e-thay . . . ittle-lay . . . onsters-may . . . o-tay . . . ed-bay?” The kids wouldn’t understand and start whining about going to bed.

Similarly, today’s brokers and economists don’t want to scare the kids (investors) by saying the dreaded “D-words” ‘cuz that might sap investor “confidence”. Sapping confidence is bad for “bidness”. Therefore, brokers and economists instead use the “pig Latin” of economics to talk about “iquidity-lay”.

My definitions

It may be true that professional definitions of “liquidity” and “illiquidity” are far more “complex and nuanced” than the ones I’m offering. Still, it’s also true that, in broad strokes, my definitions seem relatively simple (perhaps oversimplified) but understandable and workable:

“Liquidity” implies a period of inflation when prices are rising, dollars are losing value and people are happy to spend their cash on investments that will protect their wealth from inflation. If the price of a new Cadillac is $50,000 today and likely to rise to $60,000 in the next quarter, you’d better buy that car now. That’s inflation. That’s liquidity. For most practical purposes, “liquidity” means “inflation”.

“Illiquidity” corresponds to a period of deflation when prices are falling, dollars are gaining value, and people therefore refuse to spend them on investments that will expose their wealth to deflationary losses. If the price of a new Cadillac is $50,000 today and likely to fall to $40,000 in the next quarter, you’d better hang onto your cash and postpone buying for a while. That’s deflation. That’s illiquidity. For most practical purposes, “illiquidity” merely means “deflation”.

A: There are fundamentals that are powerful, irresistible and inevitable—but they’re obscured by the economists’ and government’s word games and won’t be manifest until the word games have been exposed and defeated.

Q: Is “illiquidity” bad?

A: It might be painful, but it’s not necessarily bad if you like free markets and truth.

21 responses to “‘Tis an Illiquidity that Blows No Good”

Are not all fiat currency systems, in which the principle of an INTEREST-BEARING note is LOANED in to circulation upon the AUTHORIZING signature of an ignorant borrower WITHOUT the interest portion/coupon of said note being authorized/created and issued in to circulation concurrently, the ultimate pyramid Ponzi scheme? And what is the ultimate outcome of all pyramid cons? Eventually the increasing amount of new principle-input -“liquidity” – is never adequate enough to cover the increasing amount of coupon which was never created/injected in to the “economy” also. Is the increasing pitch of that vortex/sucking-sound possibly the sound of the new “liquidity” being immediately sucked up by the “coupon holders” / bankster [D]elites? Add to that the DECREASING number of “qualified” borrowers through which said new “liquidity” is injected into the economy, One doesn’t need to apply complicated telemetry math to calculate the “path” of the in-coming gravity-captured fireball. IN-COMING! ! !: battlefield parlance for “get your butt down IMMEDIATELY”. If One is already “hunkered down”, One may have significantly increased One’s odds of “surviving to thrive” and able to assisted other Repentants in greater need.

Common law had a different outlook. Things were either fixed or movable. From Bouvier

MOVABLES, estates. Such subjects of property as attend a man’s
person wherever he goes, in contradistinction to things
immovable. (q. v.)

2. Things movable by their nature are such as may be carried
from one place to another, whether they move themselves, as
cattle, or cannot be removed without an extraneous power, as
inanimate things. Movables are further distinguished into such as
are in possession, or which are in the power of the owner, as, a
horse in actual use, a piece of furniture in a man’s own house;
or such as are in the possession of another, and can only be
recovered by action, which are therefore said to be in action, as
a debt.

Liquidity would appear to be an aspect of the movability of an object or might be a measure of the objects fungibility … the characteristic that permits one such object to be substituted for another. Money is said to be the only truly fungible thing. Conversion is an action of equity defined by Bouvier as

CONVERSION, in equity, The considering of one thing as changed
into another; for example, land will be considered as converted
into money, and treated as such by a court of equity, when the
owner has contracted to sell his estate in which case, if he die
before the conveyance, his executors and not his heirs will be
entitled to the money.

Liquidity might attend the object but the action of converting the object to either cash or another object belongs to equity. Could be that liquidity is an EQUITABLE concept as well?

All this begs the question …. How are things exchanged in Law without reverting to Equity?

Good knowledge for the few who are able to successfully APPLY it in an equity court proceeding.
For all the debt-ridden, dumbed-down, debilitated and teLIEvision distracted “Merikaan Mushroom Majority” CHOOSING to remaining vegetating of the corp media dung in the dark – just BEND OVER!

Connecting liquidity with inflation makes sense. And your acknowledgment of orthodox definitions is commendable, even when your purpose is to discard them and advance to new frontiers.

Concerning the term “liquidity”, here’s how I would restate what the financial dictionaries (in particular) say, in a more practical way:

Liquidity is the property of markets whereby a small increase in supply does not cause a significant downward spike in price.

A market is not liquid or illiquid in a single overall sense. The liquidity or illiquidity of a market is determined separately for each offer size. A market can be completely liquid (i.e. tending to maintain a roughly constant price, not downspike) for a sale of 1 unit but highly illiquid (i.e. tending to react with a downward spike in price) for a sale of 100 units.

“But, technically, they are also almost incomprehensible to 98% of the population.”

I think this overestimates people’s lack of intelligence (or whatever you want to call the relevant faculty). I’d say the correct figure is 39% of the population finds professional definitions “almost incomprehensible”. People are by nature attuned to verbal communication and can usually infer meaning with reasonable accuracy in an unfamiliar setting.

Among the readers of this blog, almost all of whom have above-average intelligence, the ability to adapt to the unfamiliar definitions found in “professional” dictionaries must be even greater.

Fair prices as determined by supply and demand in the free (unmanipulated) market. If I’m selling a car for $5,000 that most people would agree is reasonably worth about $5,000–we have liquidity. Somebody will pay $5,000 and the price of the car will continue to hover around $5,000.

But, if I’m selling the same car into the same market for $25,000, I’m not likely find even a fool willing to pay so much for so little. The car won’t be sold for the $25,000 price. I’ll probably have to drop the price a lot (maybe all the way down to $5,000) before I can sell it. If I was fool enough to have personally paid $25,000 for that car, I’m going to take and 80% loss. That’s illiquidity.

Illiquidity is a “state of market” where investors no longer believe current prices are viable. It may be that those investors previously believed current market prices were reasonable but, for whatever reason, they have abandoned that belief and will not buy unless the prices are dramatically reduced.

If “liquidity” is synonymous with a “free market,” then it might follow that illiquidity is the consequence of a manipulated, controlled, “un-free” market. If the government, banks, Federal Reserve or whoever continues to manipulate the market artificially upwards, eventually the people catch on and refuse to buy at artificially-higher, manipulated market prices.

From that perspective, illiquidity might mark the moment when the investors refuse to play the greater fool. If you happen to have been the last one to buy the $5,000 car for $25,000–too bad for you. You’re going to take an 80% loss.

You’ll scream and cry at the injustice of it all. But the truth is that you can’t con an honest man. The reason you paid $25,000 for a $5,000 car is that you were greedy and believed you could find some other fool to pay you $30,000. You’d make a fast $5,000. And he’d pay $30,000 because he expected to sell it for $35,000 to an even greater fool. But the game of greed suddenly ended, and you turned out to be the “greatest fool”–which means you’re going to lose 80% of you former assets.

Is it unjust that the greedy wind up impoverished? I can’t see how. They were looking to hustle somebody and wound up being hustled themselves. Sounds like justice to me.

Illiquidity marks the moment when the market abandons its greed, refuses to over-pay and refuses to play the “greater fool”.

Indeed, “marketability” can mean essentially the same thing as “saleability”, which is what you seem to imply with your Ford example. This is totally valid.

Another meaning of “marketability”, often used by traders in the financial markets who deal in fungibles, has the additional implication of “at the current market price”. The trading platforms the trader works with assure him that his commodity holdings can be sold at some price or another. Of more frequent interest is what quantity of his holdings he can unload under current conditions without the market moving away from him.

It’s in the latter (hopefully not too professional) sense of “marketability” that this term is used interchangeably with “liquidity”.

Several examples … De Beers … If they ever released knowledge of how many diamonds they have in their vaults the price would drop to the level of party favors. Next palladium was around $1,100 around 12 years ago until Russia traded a large amount for a PGM mine in Wyoming which drove the price below $200 for many years. Farmland was $300 an acre in the ’60s and $3,500 in the early ’80s. These prices were based upon only a few sales because nobody wanted to sell when prices were moving up. The farm crisis in the 80s saw price of farm land retreating to below $1,500 an acre.

One problem with the PPT is they either plan the peaks in stocks or just run out of liquidity.
Just as in 2000,2008, and now 2015 there are clear indications the market currently is poised to correct substantially.
Through the eyes of technical analysis in every instance in 2000, 2008 and now, the markets momentum peaked long before the price discovery appeared to have peaked, then and now.
Using a tool called Coppock Curve the market averages actually topped out in January of 2014, what we are witnessing is obvious to those in the know and can see the signals.
The PPT may actually be engineering this rollover, in it’s early stages. I reiterate, based on momentum this market is in a bear market already, only to accelerate to the downside.
What we have now, big time is derivative machinery in the form of ETF’s, these will halp the momentum to the downside, a sort of reverse leverage.
“Poetry in motion” a chart pattern that plays out as observed and expected.

Two prime examples of illiquidity are Walmart stock which in January A.D. 2015 was trading at-$80.00 US, now in August A.D. 2015–$69.00 US. Market Vector China ETF (PEK) in June A.D. 2015 was trading at $70.00 US., now roughly 6 weeks later $46.00 US. One ask when stocks fall where does the money go, to money heaven? Does it find itself somewhere else providing liquidity to another sector or stock?
Walmart and China ETF’s are the belweathers indicationg there is serious trouble with the comsumer. The breakdown in Stabucks Coffee stock will confirm the retail sector is going to follow Walmart lower. Presently there is ample liquidity available to purchase a cup of coffe and a stale bisquit for $10.00 US.This is going to change, this is the SBUX indicator.
As Junk bonks crater and lead to the equity averages cratering as well (underway) it is entirely possble this event is putting the platform under the metals and establishing the liquidity to fuel the birth of the new uncycle.
Coil dealer here in town says supply of silver is extremely tight– liquidity chaseing metals ( worldwide). No shorage of liquidity, just rotation from sector to sector.
I understand silver and gold are in a constant state of backwardation, indication severe shortage of physical.

backwardation
[ bàkwər dáysh’n ]

NOUN

1.the amount by which the price of goods for immediate delivery differs from the price of goods for delivery at a future time

2.on the London Stock Exchange, the right to delay delivery of securities purchased by somebody until the next settlement period, or the percentage paid by the seller for this right

In the event of a severe bout of illiquidity, the money doesn’t go to heaven or some such. It stays in people’s pockets. In an episode of deflation people prefer to invest their “wealth” (their energy and work) into the currency rather than stocks or bonds. They understand that the currency is growing in value while the paper investments are shrinking in value. Therefore, they invest their wealth (energy and work) into the currency rather than stocks or bonds. If the currency fails, they move on and invest their “wealth” in gold or silver. The currency is still available, but, because it’s growing in purchasing power, most people don’t want to spend it on anything. Result? Illiquidity. Result? Economic depression.

Old economic saying: You can lead an investor to a stock, but you can’t make him purchase.

There is a ratio of S&P 500 VERSES the $XAU mining index, it just reached an extreme reading, indicating that stocks should fall and mining stocks (gold) should rise. This ratio indicator marked the high in stocks as measured by the S&P 500 and the low in mining stocks in A.D. 2000. Currently it is at a more extreme level than it was then. It is indicating that gold stocks are cheaper relative to the S&P 500 now, more than they were before the onset of the advance from A.D. 2000 through A.D. 2011. An example of liquidity changes in the last cycle, thus indicating a do-over in liquidity flows at current juncture. Signals, one of many, Al I like your saying “a leaf in the breeze”.